Why is the price paid for a business sometimes different than the value determined by a business valuation?

Why is the price paid for a business sometimes different than the value determined by a business valuation?

December 17, 2015

When we prepare valuation reports, we most often do so under the standard definition of Fair Market Value (FMV). The actual price paid for a business may differ from its FMV. A detailed analysis of the standard definition can illustrate why these differences may have arisen. The standard definition of FMV is set out below:

“the highest price available in an open and unrestricted market between informed and prudent parties, under no compulsion to act and acting at arm’s length, expressed in terms of money or money’s worth.”

“…open and unrestricted market…” – Essentially, FMV is determined under optimal conditions while the conditions of an open market transaction are often less than optimal. Often the market is restricted as the potential sale isn’t open to all potential purchasers.

“…between informed and prudent parties…” – In most cases the buyer does not have the same level of knowledge of the subject company as the seller. Alternatively, the seller may not be as familiar with current market conditions as the buyer. This knowledge imbalance can drive the price for a business higher or lower depending on the relative information available to each party to the transaction.

Prudent parties implies that both parties are acting in a rational manner which is not always the case. Certain sellers may place a large sentimental value on their business and therefore not conform to the market realities. Buyers may place a large premium on a company in a certain industry if it is one that they are attracted to.

“…under no compulsion to act…” – When one of the parties to a transaction is under a compulsion to act the price could be affected in one of many different ways. Often we will see a compulsion to act on the part of the seller due to illness or their need to move on to a new phase of life. This situation may lead to the seller accepting a price less than the fair market value of the company in order to expedite the process.

“…acting at arm’s length…” – When a transaction is not conducted at arm’s length (a transaction between two related parties) many interpersonal dynamics can come into play which can affect the price of the business. A common situation would be the sale of a business between a parent and a child.

“…expressed in terms of money or money’s worth…” – Finally, fair market value is expressed in money or money’s worth. This can be boiled down to FMV being the cash price of the business. Many offers to purchase a business include some type of earn out provision, vendor financing or holdback. The equivalent cash price may differ materially from the implied purchase price with other forms of consideration.

Additional issues which can affect the price of the business can include the presence of strategic buyers or a material change in the market between the valuation date and the date of the offer of purchase.